IBM Proving That Value Investing Is Not A Form Of Market Timing

Throughout my career, I have often come across those who believe that value
investing is a form of market timing. This misconception seems to be based
on the notion that since a value investor determines the price above which
they are not willing to pay for a stock, that they are in effect timing the
market. The fallacy in this logic is that value investors are not concerned
with price, they are concerned with valuation. Therefore, I offer this article
as an attempt to clarify the differences between timing the market versus behaving
as a value investor.

The biggest difference pertains to what is being focused upon. The true value
investor is focused on the intrinsic value of the business behind the company
or stock they are interested in. To the value investor, the True Worth™ of
a company is represented by the rate of return that the earnings and cash flows
of the business are capable of generating on their (stockholder's) behalf.
Therefore, their time and focus is spent on analyzing the fundamental value
of the business. As I often do, I will look to the Oracle of Omaha to find
what the king of value investors has to say about this subject:

"I never attempt to make money on the stock market. I buy on the assumption
that they could close the market the next day and not reopen it for five
years." Warren Buffett

"The market is there only as a reference point to see if anybody is offering
to do anything foolish. When we invest in stocks, we invest in businesses." Warren
Buffett

The two above quotes really crystallize some of the key differences between
a value investor and a market timer. The true value investor, like Warren Buffett,
doesn't care if they close the market the day after he buys a stock and not
open it for five years because he doesn't plan on selling the business. In
other words, he's not really worried about what the price may or may not do
over the shorter run; his concern is with how much money the business behind
the stock will make him over the years.

And of course the second quote simply reiterates the idea of investing in
the business, not the stock. The true value investor understands that as long
as the business is strong and performs well, the stock price will eventually
seek its True Worth™, it's only a matter of time. Therefore, they are
never forecasting what the price is going to do, but they spend a great deal
of time and effort forecasting what they believe the business will do.

In contrast, the market timer is focused mainly on price, and what they believe
the price movement is going to be over the short run. In other words, they
are concerned with whether they think the price is going to go up or going
to go down, and therefore usually have little concern or even much interest
in what the business may or may not be doing. More simply stated, they are
spending their time forecasting what the price of the stock is going to do
in contrast to what the business may or may not do. I consider this folly,
because my experience has shown that stock prices are both volatile and unpredictable.

In order to illustrate my point, I'm going to draw on the perspectives provided
by F.A.S.T. Graphs™ on the tech blue-chip
International Business Machines (IBM) that will illustrate the differences
between a value investor and a market timer. To accomplish this, I will analyze
IBM first through the eyes of a market timer, then through the eyes of a value
investor.

A Hypothetical Analysis of IBM as a Market Timer

As I mentioned in my opening remarks, market timers are solely concerned with
price and price movement. Furthermore, and perhaps unfortunately, I believe
there are a lot more market timers out there than there are value investors.
Some evidence of this last fact can be seen by examining the majority of stock
charts available on the Internet. The vast majority plot and graph price only.
The following stock price chart only on IBM offers a typical example.

To the market timer focused on price, the IBM stock price chart could easily
be interpreted as follows: First of all, the market timer might consider that
IBM is not a good buy because it's selling at a price that's very close to
its 52-week high. Furthermore, they might also say that the stock has had a
large run-up and therefore is no longer a good buy. On the other hand, the
market timer may see IBM as a momentum stock and forecast that price may go
higher on momentum. Or, since we had a few down days, market timers may be
calling for a pullback. Nevertheless, their opinions will be primarily driven
by price action.

To reiterate and summarize, the market timer will utilize a lot of metrics
that are based solely on price. Examples would include 150-day moving averages,
52-week highs and of course various forms and methods of technical analysis.
The problem that I have always found with this kind of price-based analysis
is that it is long on information and short on wisdom.

The only thing that I can ever say with confidence about stock price charts
are that they will always draw a jagged picture of volatility. Although many
attempt to divine some wisdom amongst the chaos and disarray, I contend that
short-term movements are erratic and unpredictable. Therefore, I believe that
a successful forecast of the next direction in stock price is more a function
of luck than analysis. Of course, many market timers will disagree.

A Hypothetical Look at IBM as a Value Investor

The following earnings only F.A.S.T. Graphs™ on IBM looks at the same
investment only this time from the perspective of the business with no regard
to price. The orange line on the graph plots IBM's earnings per share since
calendar year 2003 to include an estimate for 2012. Using a widely accepted
formula for valuing a business based on earnings and cash flows applies a valuation
multiple (PE ratio) of 15. So that the reader is clear, there are two primary
things that are important about the orange earnings justified valuation line.

First of all, the orange earnings justified valuation line paints a picture
of a very consistent and fast-growing business since 2003 (note the operating
earnings growth rate of 14.1% to the right of the graph). In other words, we
instantly see a picture of a really good business, and price has not yet even
entered the equation. Second, we see a picture that represents a proxy of fair
evaluation on IBM (the orange earnings justified valuation line).

Although there is a mathematical justification that validates where and how
this orange line is drawn, I would like to avoid mathematical equations in
favor of concept. What the essence of this fair valuation line represents,
is a valuation level where the prospective investor earns an earnings yield
that justifies the risk of investing in the business. In other words, this
line is not intended to tell you where the price of the stock is going to go;
instead, it is designed to draw a picture where the earnings themselves of
the business provide an adequate return to shareholders.

More simply stated, if the stock price is touching this line, then fair value
is evident. And of course, if the price is above this orange line then earnings
would not justify the investment, and if the price is below this orange line
a real bargain exists. Moreover, the higher the price is above the orange line
the greater the overvaluation, and the more the price is below the orange line
the greater the bargain. Therefore, the true value investor is primarily focused
on this orange line, and stock price is only brought into the equation in order
to determine whether or not the value investor can buy the business at a sound
price or not. But the value investor is not forecasting price, the value investor
is forecasting future business growth and looking for bargains.

Although I would argue that the earnings only graph provides more wisdom with
its information than a price only graph does, I would also admit that it is
still longer on information and shorter on true knowledge. In my opinion, it
is only when the two graphs are combined (earnings and price) that the information
relative to each other begins to provide real knowledge that becomes wisdom.
Neither a price graph alone nor an earnings only graph can provide an accurate
basis that depicts a sound rationale as to whether to buy, sell or hold.

Value Investing Versus Market Timing Bringing It Together

This next graph, which is a combination of price and earnings, clearly illustrates
my point. In this graph we have overlaid monthly closing stock prices in correlation
to the orange earnings justified valuation line and discover some very important
and enlightening relationships between the two. When we examine price and earnings
simultaneously, we discover wisdom and knowledge that can help us make better
investment decisions.

First of all, we see that in the longer run price does move in the general
direction of earnings. Moreover, notice what happens when the price is overvalued,
or above the earnings line, it inevitably comes back into alignment with the
earnings justified valuation. Conversely, notice what happens when the price
is undervalued or below the earnings line. Once again it inevitably is drawn
back to the earnings justified level. And, over the long run, it is clear that
where earnings go stock price is sure to follow.

Thus far, I've attempted to illustrate my point graphically. However, I believe
it is valuable to at least understand some of the basic mathematical principles
behind the pictures. The following Estimated Earnings and Return Calculator
shows that a consensus of 27 analysts reporting to Standard & Poor's Capital
IQ forecast IBM to grow earnings at 11% per annum over the next five years.
Therefore, IBM appears to be fairly valued (price is touching the future estimated
orange earnings justified valuation line). This is in spite of the strong price
advance over the last 3-plus years because in December of 2008 IBM's stock
price was extremely undervalued. Therefore, most of the price advance that
occurred has been from stock price catching up to fair value.

In addition to the potential growth of earnings yield, the table also provides
an estimate of growth of dividend yield (yield on cost) and a calculation of
future target prices based on price following the orange line (earnings estimates).
Finally, for perspective on the risk reward ratio, a comparison with investing
in 10-year Treasury bonds is provided by the yellow columns.

Summary and Conclusions

The primary goal of this article was to provide a rational explanation about
the differences between market timing versus value investing. Market timing
deals with attempting to forecast where the next movements in price are going
to go and occur. The only concern that the true value investor has with price
is as a measurement as to whether or not it represents fair value relative
to fundamentals (earnings). Therefore, although price movement either validates
or invalidates the market timer's investing strategy, it is not even of interest
to the true value investor.

As I have stated in past writings, both the true value investor and a competent
mountain climber both realize that the only way to the highest peak is by the
willingness to traverse through several valleys along the way. However, calculating
the intrinsic value of a business based on fundamentals and then not being
willing to invest in the business unless the valuation justifies the price,
is not market timing. Instead, it is applying sound and proven principles of
business economics and accounting to the investment process.

At the end of the day, the value investor does not validate their decision
based on price movement. In fact, if price falls after they buy, and they feel
their original decision was based on sound fundamental values, the reaction
would be to buy more. Furthermore, if price rises right after they buy they
do not immediately pat themselves on the back and assume they were right. It
is only when earnings and dividends continue to advance that the real value
investor believes that they've made the correct decision.

Charles (Chuck) C. Carnevale is the creator of F.A.S.T. Graphs™. Chuck
is also co-founder of an investment management firm. He has been working in
the securities industry since 1970: he has been a partner with a private NYSE
member firm, the President of a NASD firm, Vice President and Regional Marketing
Director for a major AMEX listed company, and an Associate Vice President and
Investment Consulting Services Coordinator for a major NYSE member firm.

Prior to forming his own investment firm, he was a partner in a 30-year-old
established registered investment advisory in Tampa, Florida. Chuck holds a
Bachelor of Science in Economics and Finance from the University of Tampa.
Chuck is a sought-after public speaker who is very passionate about spreading
the critical message of prudence in money management. Chuck is a Veteran of
the Vietnam War and was awarded both the Bronze Star and the Vietnam Honor
Medal.

Disclaimer: The opinions in this document are for informational and
educational purposes only and should not be construed as a recommendation to
buy or sell the stocks mentioned or to solicit transactions or clients. Past
performance of the companies discussed may not continue and the companies may
not achieve the earnings growth as predicted. The information in this document
is believed to be accurate, but under no circumstances should a person act
upon the information contained within. We do not recommend that anyone act
upon any investment information without first consulting an investment advisor
as to the suitability of such investments for his specific situation.